#152: Stuffed

WHY THE MONETARY LIFEBOAT WON’T FLOAT

The global financial system has come to rest on a single complacent assumption, one which is seldom put explicitly into words, but is remarkably implicit in actions.

This assumption is that the authorities have, and are willing to deploy, a monetary ‘fix’ for all ills.

Accordingly, the system has come to be seen as a bizarre casino, in which winning punters keep their gains, but losers are sure that they’ll be reimbursed at the exit-door.

So ingrained has this assumption become that it’s almost heresy to denounce it for the falsity that it is.

The theme of this discussion is simply stated. It is that the complacent assumption of a monetary fix is misplaced. The authorities, faced with a crash, might very well try something along these lines, and might even adopt one or more of its most outlandish variants.

But it won’t work.

The reason why no monetary expedient can provide a “get out of gaol free” card is that the economy and the financial system are quite different things.

The complacent rush in  

You can see financial manifestations of mistaken complacency wherever you look.

It emboldens those who have lent most of the $2.9 trillion that, over the last five years, American companies have ploughed into the insane elimination of flexible equity in favour of inflexible debt.

It informs those who pile into the shares of cash-burners, or queue up to buy into overpriced IPOs.

It reassures those long of JPY, despite the monetization of more than half of all outstanding JGBs by the BoJ.

It tranquilizes those who, unable to see the contradiction between gigantic financial exposure and a stumbling economy, remain long of GBP.

It blinds those to whom the Chinese economic narrative remains a miracle, not a credit-fueled bubble.

The aim here is a simple one. It is to counter this complacency by explaining why economic problems cannot be solved with monetary tools, and to warn that efforts to do so risk, instead, the undermining of the credibility of currencies.

A casino which hands back losers’ money belongs in the realm of pure myth.

The secondary status of money

Money has no intrinsic worth. Someone adrift in a lifeboat in mid-Atlantic, or stranded in the Sahara, would benefit from an air-drop of food or water, but even a gigantic amount of money descending on a parachute would do nothing more than allowing him or her to die rich.

Conventionally, money has three roles, but only one of these is relevant. Fiat money has been an atrociously bad ‘store of value’, and money is a very flawed ‘unit of account’. Money’s only relevant role is as a ‘medium of exchange’.

For this to work, there has to be something for which money can be exchanged.

This means that money has no intrinsic worth, but commands value only as a claim on the products of the economy. If you build up a structure of claims that the economy cannot honour, then that structure must – eventually, and in one way or another – collapse.

Conceptually, it’s useful to think in terms of ‘two economies’. One of these is the ‘real’ economy of goods and services, its operation characterised by the use of labour and resources, but its performance ultimately driven by energy.

The other is the ‘financial’ economy of money and credit, a parallel or shadow of the ‘real’ economy, useful for managing the real economy, but wholly lacking in stand-alone substance.

To be sure, the early monetarists oversimplified things with the assertion that inflation could be explained in wholly quantitative monetary terms. The price interface between money and the real economy isn’t determined by the simple division of the quantity of economic goods into the quantity of money.

Rather, it’s the movement or use of money that matters. The quantitative recklessness of Weimar would not have triggered hyperinflation had the excess been locked up in a vault, or in some other way not put to use. It’s not hair-splitting, but an important distinction, that Weimar’s true downfall was not that excess money was created, but that it was created and spent.

The process of exchange, which really defines the role of money, makes the interface dynamic, and, as such, introduces behavioural considerations. The creation of very large amounts of new money needn’t destabilize the price equilibrium if people hoard it, but a lesser increment can be extremely destabilizing if is spent with exceptional rapidity. This is why the simple quantitative interpretation needs to be modified by the inclusion of velocity, making Q x V a much more useful monetary determinant.

Behaviourally, velocity falls when people turn cautious – they did this during and after the 2008 global financial crisis (GFC), a tendency which reduced the inflationary risk of the loose money responses deployed at that time.

Even so, claims that the monetary adventurism unleashed at that time did not trigger inflation are simply untrue, unless you accept a narrow definition of inflation. To be sure, retail prices haven’t surged since 2008, but asset prices most certainly have, the truism being that the inflationary effects of the injection of money turn up at the point at which the money is injected.

Additionally, inflation is influenced by expectations – which have been low in an era of ’austerity’ – and by the performance of the economy. An economy which is performing weakly puts downwards pressure on inflation.

What it does not do, though, is to eliminate latent inflation. Any erosion of faith in the reliability of money would cause velocity to spike, as people rush out to spend it whilst it still has value.

Fiat fallacy

One of the analytically adverse side-effects of monetary manipulation is that it inflates apparent activity. Globally, and expressed in constant 2018 PPP dollars, the $34tn increase in recorded GDP since 2008 cannot be unrelated to the $110tn escalation in debt over the same period. According to SEEDS, most (67%) of the “growth” recorded over that period was nothing more than the simple effect of spending borrowed money.

This matters, first because a cessation in credit injection would undermine supposed rates of “growth” and, second, because a reversal would put much prior “growth” into reverse.

By falsifying GDP, this ‘credit effect’ also falsifies any relationships based on it – so the ‘comfortable’ 218% global ratio of debt-to-GDP masks a real ratio which is nearer to 340%, and higher by more than 100% than it was ten years ago (236%). It also distorts the measurement of financial exposure, so lulling us into misplaced insouciance about those countries (such as Ireland and Britain) whose financial assets stand at huge multiples to the real value of their economies.

Behind the mask of ‘the credit effect’, global economic performance is at best lacklustre, growing at about 0-9-1.3% annually whilst population numbers are growing by 1.0%.

Moreover, these numbers disguise regional disparities – whilst the average Chinese or Indian citizen continues to become more prosperous (for now, anyway), the average Westerner has been getting poorer for at least a decade.

Of course, there’s a countervailing ‘wealth effect’, giving false comfort to those whose assets have soared in price – and few, if any, of them appear to wonder what would happen if there was a rush to monetize inflated values.

But the drastic distortion in the relationship between asset values and incomes has real downsides exceeding its (illusory anyway) upside. Policymakers and their advisers may remain ignorant of the deterioration in Western prosperity, but to voters it is all too real, something which has been a major contributor to those changes in voter responses which have informed “Brexit”, Mr Trump’s ascent to the White House, and the rolling repudiation of established political parties across much of Europe.

The decline of “stuff”

The weakness of the underlying picture has now started showing up unmistakeably in weakening in demand for everything from cars, domestic appliances and smartphones to chips and drive-motors. Logically, deterioration in the economy of “stuff” will extend next into commodities because, if you’re making less “stuff”, you need less minerals, less plastics and, critically, less energy with which to make it.

Whilst all of this is going on in plain view, markets and policymakers alike are failing to recognize the risks implicit in the widening gap between a stumbling economy and escalating financial exposure. As well as borrowing an additional $110tn since 2008, we’ve blown a not-dissimilar-sized hole in pension provision, because the same low cost of capital which has incentivized borrowing has also crippled the rates of return on which pension accrual depends.

Additionally, of course, the prices of equities and property have reached heights from which any descent into rationality would have devastating direct and collateral consequences.

When the next crisis (GFC II) shows up, the complacent expectation is that everything can be ‘fixed’ with even looser monetary policy. Some of the more bizarre suggestions aired in 2008 – including ‘helicopter money’, and NIRP (negative interest rate policy, with its implicit need to outlaw cash) – will doubtless come to the fore again, accompanied by a whole crop of new ‘innovations’. The authorities are likely, in the stark despair which follows protracted denial, to act on at least some of these follies.

The trouble is that it won’t work.

You might as well try to rescue an ailing pot-plant with a spanner as try to revive an ailing economy with monetary innovation.

The form that failure takes need not necessarily involve massive inflation, though this is the only non-default route down from the debt mountain. Authorities capable of believing that EVs are “zero emissions”, or that we can overcome the environmental challenge with some form of “sustainable growth” (rather than degrowth), are perfectly capable of also believing that we can fix economic problems with monetary recklessness.

If inflation doesn’t spoil the party, two other factors might. One is credit exhaustion, in which massively indebted borrowers refuse to take on yet more debt, irrespective of how cheap the offer may be.

The other factor might well be a loss of faith in money, which might also be accompanied by a ‘flight to quality’, perhaps favouring the dollar (as ‘the prettiest horse in the knackers’ yard’), whilst hanging weaker currencies out to dry.

However it pans out, though, we know that an economy whose prosperity is faltering cannot indefinitely sustain an ever-growing burden of financial promises. By definition, whatever is unsustainable eventually fails, and this is as true of monetary systems as of anything else.

#151: The Great (brick) Wall of China

HOW SERIOUS IS THE CHINESE DOWNTURN?

For more than ten years, capital markets have had one perennial obsession, with Wall Street, in particular, rising or falling with the latest change of sentiment over Fed rate policy. Now, though, a new fixation has taken over, with stock markets reacting to every slightest positive or adverse nuance in trade talks between China and the United States.

These obsessions share an irony, which is that the outcome of neither has ever been in much doubt.

On rate policy, and even when Fed comments have been at their most bullish, there’s never been much real chance of rates rising back towards what, pre-2008, was considered “normal”. After a ten-year-long debt binge, followed by more than a decade of ultra-loose monetary policy, the American and world economies are locked into an abnormality which must continue until it reaches its culminating failure.

Pushing rates up to, say, 250bps above inflation would crash the economy, and everybody knows it. At each and every downturn in sentiment and performance, central banks are going to reach for the taps, until either credit exhaustion, and/or the loss of faith in money, puts the experiment of ‘financial adventurism’ out of its misery – and, if we’re lucky, triggers ‘the great reset’.

With Sino-American trade, the probabilities are equally loaded, and there’s never been any real chance at all of a meaningful agreement being reached between Washington and Beijing. The reality is that, for reasons seldom understood by Western observers,  but explained here, China simply cannot agree to terms that would satisfy the White House.

Through the wrong lens

Part of the perception problem is that outsiders habitually look at China through Western eyes, assuming that, like Western countries, China concentrates on the pursuit of profitable growth. This, unfortunately, simply isn’t the case. China’s priorities in economic policy are wholly different, with profitability mattering hardly at all, and the focus emphatically on volume.

The basis of government in China is “the mandate of heaven”, a term which translates as government by consent. To be sure, China has impressively comprehensive surveillance and coercion capabilities, but nobody should assume that these could keep the party (the CPC) in power if the public turned against it.

Rather, the relationship between governing and governed rests on a “grand bargain”. The public’s side of this bargain is the acceptance of civil rights which are a lot more restricted than has been the norm in the West. In return, the authorities are required to deliver prosperity.

This, undoubtedly, they have thus far succeeded in doing. According to SEEDS (the Surplus Energy Economics Data System), the average Chinese person is 44% more prosperous now than he or she was just ten years ago. This achievement is all the more remarkable when set against the gradual but relentless deterioration of prosperity in the West.

Nobody should assume, though, that continuation of improvements in prosperity is assured. Rather, the bar keeps getting higher, and one of the themes explored here is the growing extent to which China has had to resort to increasingly dangerous financial expedients to keep prosperity growth on track.

The litmus-test of whether the government is keeping its side of the bargain is employment, especially in urban areas. Both theory and evidence illustrate that, whilst rural unemployment seldom brings about unmanageable unrest, urban unemployment both can, and has. The spectre which stalks the nightmares of the Chinese leadership is mass unemployment in the cities, a problem whose potential risk has grown steadily as millions have migrated from the countryside.

At all costs, then, China must sustain and grow urban employment. This in turn points to two criteria seldom recognized in the West – an emphasis on activity (rather than profit), and a single-minded concentration on volume (rather than value).

If China were to agree to restrict her exports of goods to the United States, her volume priority would take a huge hit – and meeting America stipulations on technology transfer could risk China’s goods falling so far behind competitor product specs that they would be barely saleable, almost irrespective of quite how far prices were allowed to fall.

These considerations indicate that China simply cannot afford to agree to the most important American demands over trade, which makes a deal implausible unless Washington backs down. The view taken here is that, whilst the United States can ‘win’ a trade war with China, such a victory could be Pyrrhic at best. Based on the analysis outlined here, the Chinese economy is already in very big trouble, and America can only lose if this predicament is worsened.

The paramount emphasis on volume goes along way towards explaining why China has built huge capacity, even where there are already excesses. Building residential property where there are no residents, shopping centres without retailers, unnecessary infrastructure and unneeded factory capacity may look irrational in the West, but what to Westerners may be a white elephant looks, in China, like a valuable source of employment.

Emphasis on volume does, though, come at a hefty cost. In industry, the creation of excess capacity necessarily crushes margins. As a result, profitability often falls to levels below the cost of capital, whilst cash flow is nowhere near sufficient to finance investment in additional capacity.

This, in turn, has forced a reliance on debt, which is used not just to fund capacity expansion, but to cover losses as well.

Overseas observers customarily ignore China’s reliance on debt, sometimes because they are simply dazzled by reported “growth”. Many people overseas marvel that China has more than doubled her GDP (+114%) since 2008, but far fewer recognize that doing this has required a near-quadrupling of debt (+284%) over the same period.

In the years since the 2008 global financial crisis (GFC), annual net borrowing in China has averaged 24% of GDP, a ratio to which not even Ireland has come close.

Stated at constant 2018 values, a RMB 47.3 trillion expansion in GDP has been accompanied by RMB 162 tn escalation in debt. Tellingly, almost 60% of that borrowing has been undertaken by businesses, whose debt at constant values has climbed to RMB 134 tn, now from just RMB 38 tn ten years ago.

The cracks appear

Unfortunately, both in activity and in finance, China seems to have hit a brick wall in the second half of last year.

Financially, the first cracks in the system showed up with a catastrophe in P2P (peer-to-peer) lending, a boom-to-bust event with distinct parallels to the subprime mortgage disaster experienced in the US and in other Western countries in the lead-up to 2008.

Like subprime, P2P offers high-cost loans to borrowers unable to obtain credit from conventional (and much less expensive) sources. The very fact that borrower quality is so low ought to warn investors off these platforms, but the allure of high yields has proved irresistible to many Chinese savers.

First legalized in 2015, numbers of P2P platforms exploded, to a peak of over 8,000 by mid-2018, by which point the sums invested had reached the equivalent of $190bn. Then, with grim inevitability, P2P began to disintegrate, with some borrowers defaulting, whilst others simply absconded. By the end of July last year, after regulators had started to involve themselves, more than 4,700 P2P platforms had ceased to exist.

This in turn has had seriously adverse economic effects, some of which put the first visible dent into Chinese volumetric progression. The sectors hit first by the P2P crash have been the sales of vehicles and domestic appliances, both of which had benefited from P2P-funded purchasing.

Within corporate borrowing, China has followed the West in making ever greater use of bond finance rather than bank lending. From negligible levels ten years ago, Chinese corporate bond issuance soared to $590bn in 2016, and has remained at very high levels since then, dwarfing all other emerging market (EM) issuance put together. The number of issuers has soared to 1,451 from just 68 ten years earlier, whilst the outstanding aggregate has climbed from $4tn to almost $20tn.

Of course, China hasn’t been the only reckless user of bond issuance – indeed, the American use of bond finance for stock buybacks belongs in its own category of insanity – but, once again, cracks are starting to emerge, and are showing up in defaults.

According to US credit rating agency Fitch, defaults by Chinese companies soared to record levels last year, with 45 companies defaulting on a total of 117 bond issues. Of these companies, six were state-owned entities (SOEs), whose failures give the lie to the long-standing investor assumption that Beijing would never allow an SOE to default.

A particular complication in China is that domestic credit rating agencies seem to be ‘generous’ in the ratings that they confer. The inferred claim that most Chinese corporate bond issues are rated AA or above – with very few in junk territory – simply defies logic. A significant number of Chinese corporates enjoy AAA ratings, something that only two American companies have been accorded.

The risk here is not simply that rates of default will continue to accelerate, but that companies will face escalating debt service costs as their status slides from investment grade into junk.

An additional twist has been defaults by companies which, according to reported numbers, should have had cash holdings far exceeding the sums on which they defaulted. One company defaulted on bonds worth RMB 139 million despite supposedly having cash of about RMB 4 billion in cash holdings. A second, supposedly sitting on RMB 4.9 bn in cash, defaulted on a bond worth just RMB 300m. A third defaulted on a RMB 1bn bond even though cash had been reported at RMB 15bn.

Thus far in 2019, default rates are continuing to soar. In the first four months of this year, Chinese companies have defaulted on RMB 39.2 bn ($5.78bn) of domestic bonds, 3.4 times the total for the same period in 2018.

Tumbling volumes

These disturbing financial trends are showing up in some dramatic reversals in economic activity.

First to suffer were sales of vehicles and domestic appliances, both of which had hitherto been funded extensively with P2P credit. In comparison with year-earlier figures, sales of cars in China fell by nearly 12% in September and October last year, by 13.9% in November and by 13.0% in December. These falls constituted a dramatic reversal in hitherto uninterrupted, multi-year expansion in annual car purchasing, which had soared from 5.2 million units in 2006 to 24.7 million in 2017. Though foreign car-makers have suffered sharp decreases in sales, domestic manufacturers have borne the brunt of the slump, an event which has had very severe consequences for businesses which supply the vehicle industry.

Industries in China have also suffered from a sharp downturn in the market for consumer goods, ranging from smartphones to domestic appliances, the latter being hit further by tightened regulations on multiple home ownership. Overseas investors started to notice these trends when they were reported by companies operating in China, though, for the more observant, the sharp deterioration had been flagged already by troubled component suppliers.

Apple was one of many companies caught flat-footed by the reversal in the Chinese market, admitting ruefully that “we did not foresee the magnitude of the economic deceleration, particularly in Greater China”.

Even more significantly, suppliers of industrial components started to suffer from sharp falls in orders. The CEO of Nidec – a Japanese supplier of electric motors to manufacturers of products which include disc-drives, vehicles, robotics and domestic appliances – has said that “[w]hat we witnessed in November and December was just extraordinary”. In a letter to shareholders, Nidec called recent events “a real punch in the gut”.

FedEx, another company shocked by the Chinese turndown, has said that “no markets will be able to absorb more than a fraction of what China produces”.

The magnitude of the downturn in China is now showing up in global macroeconomic indicators – trade volumes have slumped with a rapidity not seen since 2008, whilst flows of FDI (foreign direct investment) have fallen far more sharply than can be explained by US tax changes alone.

There is growing evidence, too, that Chinese investors have started pulling out of property and other investments in overseas markets. Even before trade disputes really heated up, Chinese FDI in the United States had collapsed, whilst Chinese investors were also scaling back their investments in Europe. Towards the end of last year, in a clear reflection of economic deterioration, Chinese equity markets fell sharply, tumbling to levels last seen before the 2008 crash.

Turning on the taps

Inevitably – and despite prior commitments to do no such thing – the Chinese authorities have been pouring eye-watering amounts of new liquidity into the system since the start of this year. This has helped Chinese capital markets recover, of course, but seems to have done nothing more than buy some time for the economy itself, with key volume indicators (such as vehicle sales) continuing to fall sharply.

These interventions are starting to get noticed, puncturing much long-standing overseas complacency about China as an ‘unstoppable growth engine’. Pointedly, Forbes magazine recently asked why, if the Chinese economy really is growing at over 6%, “is the People’s Bank of China (PBOC) pumping money into the market like a drunken sailor?”

It may not be at all fanciful to detect a sense of near-panic in Beijing. Having already called on state banks to lend more to SMEs (small- and medium-sized enterprises), Premier Li Keqiang has now called for greater “flexibility” in the use of monetary policy to encourage lending. The word “flexibility”, of course, has a particular meaning when applied to monetary policy.

As well as implementing stock purchases, the PBOC has loosened reserve requirements – enabling banks to increase lending against any given amount of capital – and seems to be relaxing some of the rules previously put in place to restrain the bubble in residential property prices. Credit stimulus totalled RMB 4.64tn – more than 5% of annual GDP – in January alone, and has continued throughout the year so far at rates suggesting that 2019 will witness another big leap in Chinese indebtedness.

What now?

What we’re seeing, then, is the first major setback to an economic model targeted on volume and supported by ultra-rapid credit expansion. Though some of us have been warning about the pace of Chinese debt expansion over an extended period, Western markets seem only to have become aware of these risks since volumetric indicators turned down, a trend whose impact has been highlighted by its consequences for a string of overseas companies which, hitherto, had been riding the expansionary wave in Chinese economic activity.

Perhaps the single most disturbing feature of the Chinese predicament has been the sheer scale of the downturn across a string of product categories ranging from cars and smartphones to industrial components. What we’ve been witnessing, across a diverse and representative cross-section of activity, hasn’t been a minor reversal, still less a slowing of growth, but an alarmingly deep fall in activity.

It need hardly be said that China has played an absolutely pivotal role in the world economy since 2008, not just providing growth but acting as a hugely important market for everything from manufactured goods to critical commodities, including energy, minerals and food. Additionally, Chinese overseas investment has been hugely important for overseas asset prices, most obviously in real estate.

The risks from here are (a) that activity continues to fall rapidly, and (b) that the financial system that has funded the push for volume starts to decay.

We can be pretty sure that, in terms of stimulus, China will do anything and everything possible to arrest the downwards lurch. Even on a comparatively optimistic reading, however, trade, investment and demand, worldwide, are going to take a major hit from what has already happened in China.

The really big question, in China as elsewhere, is whether the efficacy of financial stimulus will weaken, something which could happen if credit exhaustion kicks in, or if faith in money is undermined.

It’s worth reminding ourselves of quite how far we have already gone in reliance on cheap debt and abundant liquidity. Over five years, only stock buybacks of $2.95tn, mostly debt-financed, have kept Wall Street buoyant in the face of net investor selling of $1.1tn, whilst the Bank of Japan has now acquired more than half of all outstanding JGBs (Japanese government bonds) using money newly created for the purpose.

Stirring Chinese economic and financial risk into the mix suggests that we may be measurably close to the point at which the seaworthiness of the ‘perpetual cheap money lifeboat’ meets its toughest test.

#149: The big challenges

HOW THE ECONOMICS OF ENERGY VIEWS THE AGENDA

As regular readers will know, this site is driven by the understanding that the economy is an energy system, and not (as conventional thinking assumes) a financial one. Though we explore a wide range of related issues (such as the conclusion that energy supply is going to need monetary subsidy), it’s important that we never lose sight of the central thesis. So I hope you’ll understand the need for a periodic restatement of the essentials.

If you’re new to Surplus Energy Economics, what this site offers is a coherent interpretation of economic and financial trends from a radically different standpoint. This enables us to understand issues that increasingly baffle conventional explanations.

This perspective is a practical one – nobody conversant with the energy-based interpretation was much surprised, for instance, when Donald Trump was elected to the White House, when British voters opted for “Brexit”, or when a coalition of insurgents (aka “populists”) took power in Rome. The SEE interpretation of prosperity trends also goes a long way towards explaining the gilets jaunes protests in France, protests than can be expected in due course to be replicated in countries such as the Netherlands. We’re also unpersuaded by the exuberant consensus narrative of the Chinese economy. The proprietary SEEDS model has proved a powerful tool for the interpretation of critical trends in economics, finance and government.

The aim here, though, isn’t simply to restate the core interpretation. Rather, there are three trends to be considered, each of which is absolutely critical, and each of which is gathering momentum. The aim here is to explore these trends, and share and discuss the interpretations of them made possible by surplus energy economics.

The first such trend is the growing inevitability of a second financial crisis (GFC II), which will dwarf the 2008 global financial crisis (GFC), whilst differing radically from it in nature.

The second is the progressive undermining of political incumbencies and systems, a process resulting from the widening divergence between policy assumption and economic reality.

The third is the clear danger that the current, gradual deterioration in global prosperity could accelerate into something far more damaging, disruptive and dangerous.

The vital insight

The centrality of the economy is the delivery of goods and services, literally none of which can be supplied without energy. It follows that the economy is an energy system (and not a financial one), with money acting simply as a claim on output which is itself made possible only by the availability of energy. Money has no intrinsic worth, and commands ‘value’ only in relation to the things for which it can be exchanged – and all of those things rely entirely on energy.

Critically, all economic output (other than the supply of energy itself) is the product of surplus energy – whenever energy is accessed, some energy is always consumed in the access process, and surplus energy is what remains after the energy cost of energy (ECoE) has been deducted from the total (or ‘gross’) amount that is accessed.

This makes ECoE a critical determinant of prosperity. The distinguishing feature of the world economy over the last two decades has been the relentless rise in ECoE. This process necessarily undermines prosperity, because it erodes the available quantity of surplus energy. We’re already seeing this happen – Western prosperity growth has gone into reverse, and progress in emerging market (EM) economies is petering out. Global average prosperity has already turned down.

The trend in ECoE is determined by four main factors. Historically, ECoE has been pushed downwards by broadening geographical reach and increasing economies of scale. Where oil, natural gas and coal are concerned, these positive factors have been exhausted, so the dominating driver of ECoE now is depletion, a process which occurs because we have, quite naturally, accessed the most profitable (lowest ECoE) resources first, leaving costlier alternatives for later.

The fourth driver of ECoE is technology, which accelerates downwards tendencies in ECoE, and mitigates upwards movements. Technology, though, operates within the physical properties of the resource envelope, and cannot ‘overrule’ the laws of physics. This needs to be understood as a counter to some of the more glib and misleading extrapolatory assumptions about our energy future.

The nature of the factors driving ECoE indicates that this critical factor should be interpreted as a trend. According to SEEDS – the Surplus Energy Economics Data System – the trend ECoE of fossil fuels has risen exponentially, from 2.6% in 1990 to 4.1% in 2000, 6.7% in 2010 and 9.9% today. Since fossil fuels continue to account for four-fifths of energy supply, the trend in overall world ECoE has followed a similarly exponential path, and has now reached 8.0%, compared with 5.9% in 2010 and 3.9% in 2000.

For fossil fuels alone, trend ECoE is projected to reach 11.8% by 2025, and 13.5% by 2030. SEEDS interpretation demonstrates that an ECoE of 5% has been enough to put prosperity growth into reverse in highly complex Western economies, whilst less complex emerging market (EM) economies hit a similar climacteric at ECoEs of about 10%. A world economy dependent on fossil fuels thus faces deteriorating prosperity and diminishing complexity, both of which pose grave managerial challenges because they lie wholly outside our prior experience.

Mitigation, not salvation

This interpretation – reinforced by climate change considerations – forces us to regard a transition towards renewables as a priority. It should not be assumed, however, that renewables offer an assured escape from the implications of rising ECoEs, still less that they offer a solution that is free either of pain or of a necessity for social adaption.

There are three main cautionary factors around the ECoE capabilities of solar, wind and other renewable sources of energy.

The first cautionary factor is “the fallacy of extrapolation”, the natural – but often mistaken – human tendency to assume that what happens in the future will be an indefinite continuation of the recent past. It’s easy to assume that, because the ECoEs of renewables have been falling over an extended period, they must carry on falling indefinitely, at a broadly similar pace. But the reality is much more likely to be that cost-reducing progress in renewables will slow when it starts to collide with the limits imposed by physics.

Second, projections for cost reduction ignore the derivative nature of renewables. Building, say, a solar panel, a wind turbine or an electrical distribution system requires inputs currently only available courtesy of the use of fossil fuels. In this specialised sense, solar and wind are not so much ‘primary renewables’ as ‘secondary applications of primary fossil input’.

We may reach the point where these technologies become ‘truly renewable’, in that their inputs (such as minerals and plastics) can be supplied without help from oil, gas or coal.

But we are certainly, at present, nowhere near such a breakthrough. Until and unless this point is reached, the danger exists that that the ECoE of renewables may start to rise, pushed back upwards by the rising ECoE of the fossil fuel sources on which so many of their inputs rely.

The third critical consideration is that, even if renewables were able to stabilise ECoE at, say, 8% or so, that would not be anywhere near low enough.

Global prosperity stopped growing before ECoE hit 6%. British prosperity has been in decline ever since ECoE reached 3.6%, and an ECoE of 5.5% has been enough to push Western prosperity growth into reverse. As recently as the 1960s, in what we might call a “golden age” of prosperity growth, ECoE was well below 2%. Even if renewables could stabilise ECoE at, say, 8% – and that’s an assumption which owes much more to hope than calculation – it wouldn’t be low enough to enable prosperity to stabilise, let alone start to grow again.

SEEDS projections are that overall world ECoE will reach 9% by 2025, 9.7% by 2030 and 11% by 2040. These projections are comparatively optimistic, in that progress with renewables is expected to blunt the rate of increase in trend ECoE. But we should labour under no illusion that the downwards tendency in prosperity can be stemmed, less still reversed. Renewables can give us time to prepare and respond, but are not going to take us back to a nirvana of low-cost energy.

This brings us to the three critical issues driven by rising ECoE and diminishing prosperity.

Challenge #1 – financial shock

An understanding of the energy basis of the economy puts us in possession of a coherent narrative of recent and continuing tendencies in economics and finance. Financially, in particular, the implications are disquieting. There is overwhelming evidence pointing towards a repetition of the 2008 global financial crisis (GFC), in a different form and at a very much larger scale.

From the late 1990s, with ECoEs rising beyond 4%, growth in Western prosperity began to peter out. Though “secular stagnation” was (and remains) the nearest that conventional interpretation has approached to understanding this issue, deceleration was noticed sufficiently to prompt the response known here as “credit adventurism”.

This took the form of making credit not only progressively cheaper to service but also much easier to obtain. This policy was also, in part, aimed at boosting demand undermined by the outsourcing of highly-skilled, well-paid jobs as a by-product of ‘globalization’. “Credit adventurism” was facilitated by economic doctrines which were favourable to deregulation, and which depicted debt as being of little importance.

The results, of course, are now well known. Between 2000 and 2007, each $1 of reported growth in GDP was accompanied by $2.08 of net new borrowing, though ratios were far higher in those Western economies at the forefront of credit adventurism. The deregulatory process also facilitated a dangerous weakening of the relationship between risk and return. These trends led directly to the 2008 global financial crisis.

Responses to the GFC had the effect of hard-wiring a second, far more serious crash into the system. Though public funds were used to rescue banks, monetary policy was the primary instrument. This involved slashing policy rates to sub-inflation levels, and using newly-created money to drive bond prices up, and yields down.

This policy cocktail added “monetary adventurism” to the credit variety already being practiced. Since 2007, each dollar of reported growth has come at a cost of almost $3.30 in new debt. Practices previously confined largely to the West have now spread to most EM economies. For example, over a ten-year period in which growth has averaged 6.5%, China has typically borrowed 23% of GDP annually.

Most of the “growth” supposedly created by monetary adventurism has been statistically cosmetic, consisting of nothing more substantial than the simple spending of borrowed money. According to SEEDS, 66% of all “growth” since 2007 has fallen into this category, meaning that this growth would cease were the credit impulse to slacken, and would reverse if we ever attempted balance sheet retrenchment. As a result, policies said to have been “emergency” and “temporary” in nature have, de facto, become permanent. We can be certain that tentative efforts at restoring monetary normality would be thrown overboard at the first sign of squalls.

Advocates of ultra-loose monetary policy have argued that the creation of new money, and the subsidizing of borrowing, are not inflationary, and point at subdued consumer prices in support of this contention. However, inflation ensuing from the injection of cheap money can be expected to appear at the point at which the new liquidity is injected, which is why the years since 2008 have been characterised by rampant inflation in asset prices. Price and wage inflation have been subdued, meanwhile, by consumer caution – reflected in reduced monetary velocity – and by the deflationary pressures of deteriorating prosperity. The current situation can best be described as a combination of latent (potential) inflation and dangerously over-inflated asset prices.

All of the above points directly to a second financial crisis (GFC II), though this is likely to differ in nature, as well as in scale, from GFC I. Because “credit adventurism” was the prime cause of the 2008 crash, its effects were concentrated in the credit (banking) system. But GFC II, resulting instead from “monetary adventurism”, will this time put the monetary system at risk, hazarding the viability of fiat currencies.

In addition to mass defaults, and collapses in asset prices, we should anticipate that currency crises, accompanied by breakdowns of trust in currencies, will be at the centre of GFC II. The take-off of inflation should be considered likely, not least because no other process exists for the destruction of the real value of gargantuan levels of debt.

Finally on this topic, it should be noted that policies used in response to 2008 will not work in the context of GFC II. Monetary policy can be used to combat debt excesses, but problems of monetary credibility cannot, by definition, be countered by increasing the quantity of money. Estimates based on SEEDS suggest that GFC II will be at least four orders of magnitude larger than GFC I.

Challenge #2 – breakdown of government

Until about 2000, the failure of conventional economics to understand the energy basis of economic activity didn’t matter too much, because ECoE wasn’t large enough to introduce serious distortions into its conclusions. Put another way, the exclusion of ECoE gave results which remained within accepted margins of error.

The subsequent surge in ECoEs, however, has caused the progressive invalidation of all interpretations from which it is excluded.

What applies to conventional economics itself applies equally to organisations, and most obviously to governments, which use it as the basis of their interpretations of policy.

The consequence has been to drive a wedge between policy assumptions made by governments, and underlying reality as experienced by individuals and households. Even at the best of times – which these are not – this sort of ‘perception gap’ between governing and governed has appreciable dangers.

Recent experience in the United Kingdom illustrates this process. Between 2008 and 2018, GDP per capita increased by 4%, implying that the average person had become better off, albeit not by very much. Over the same period, however, most (85%) of the recorded “growth” in the British economy had been the cosmetic effect of credit injection, whilst ECoE had risen markedly. For the average person, then, SEEDS calculates that prosperity has fallen, by £2,220 (9%), to £22,040 last year from £24,260 ten years previously. At the same time, individual indebtedness has risen markedly.

With this understood, neither the outcome of the 2016 “Brexit” referendum nor the result of the 2017 general election was much of a surprise, since voters neither (a) reward governments which preside over deteriorating prosperity, nor (b) appreciate those which are ignorant of their plight. This was why SEEDS analysis saw a strong likelihood both of a “Leave” victory and of a hung Parliament, outcomes dismissed as highly improbable by conventional interpretation.

Simply put, if political leaders had understood the mechanics of prosperity as they are understood here, neither the 2016 referendum nor the 2017 election might have been triggered at all.

Much the same can be said of other political “shocks”. When Mr Trump was elected in 2016, the average American was already $3,450 (7%) poorer than he or she had been back in 2005. The rise to power of insurgent parties in Italy cannot be unrelated to a 7.9% deterioration in personal prosperity since 2000.

As well as reframing interpretations of prosperity, SEEDS analysis also puts taxation in a different context. Between 2008 and 2018, per capita prosperity in France deteriorated by €1,650 which, at 5.8%, isn’t a particularly severe fall by Western standards. Over the same period, however, taxation increased, by almost €2,000 per person. At the level of discretionary, ‘left-in-your-pocket’ prosperity, then, the average French person is €3,640 (32%) worse off now than he or she was back in 2008.

This makes widespread popular support for the gilets jaunes protestors’ aims extremely understandable. Though no other country has quite matched the 32% deterioration in discretionary prosperity experienced in France, the Netherlands (with a fall of 25%) comes closest, which is why SEEDS identifies Holland as one of the likeliest locales for future protests along similar lines. It is far from surprising that insurgent (aka “populist”) parties have now stripped the Dutch governing coalition of its Parliamentary majority. Britain, where discretionary prosperity has fallen by 23% since 2008, isn’t far behind the Netherlands.

These considerations complicate political calculations. To be sure, the ‘centre right’ cadres that have dominated Western governments for more than three decades are heading for oblivion. Quite apart from deteriorating prosperity – something for which incumbencies are likely to get the blame – the popular perception has become one in which “austerity” has been inflicted on “the many” as the price of rescuing a wealthy “few”. It doesn’t help that many ‘conservatives’ continue to adhere to a ‘liberal’ economic philosophy whose abject failure has become obvious to almost everyone else.

This situation ought to favour the collectivist “left”, not least because higher taxation of “the rich” has been made inescapable by deteriorating prosperity. But the “left” continues to advocate higher levels of taxation and public spending, an agenda which is being invalidated by the erosion of the tax base which is a concomitant of deteriorating prosperity.

Moreover, the “left” seems unable to adapt to a shift towards prosperity issues and, in consequence, away from ideologically “liberal” social policy. Immigration, for example, is coming to be seen by the public as a prosperity issue, because of the perceived dilutionary effects of increases in population numbers.

The overall effect is that the political “establishment”, whether of “the right” or of the “the left”, is being left behind by trends to which that establishment is blinded by faulty economic interpretation.

The discrediting of established parties is paralleled by an erosion of trust in institutions and mechanisms, because these systems cannot keep pace with the rate at which popular priorities are changing. To give just one example, politicians who better understood the why of the “Brexit” referendum result would have been better equipped to recognize the dangers implicit in being perceived as trying to thwart or divert it.

The final point to be considered under the political and governmental heading is the destruction of pension provision. One of the little-noted side effects of “monetary adventurism” has been a collapse in rates of return on invested capital. According to the World Economic Forum, forward returns on American equities have fallen to 3.45% from a historic 8.6%, whilst returns on bonds have slumped from 3.6% to just 0.15%. It is small wonder, then, that the WEF identifies a gigantic, and rapidly worsening, “global pension timebomb”. As and when this becomes known to the public – and is contrasted by them with the favourable circumstances of a tiny minority of the wealthiest – popular discontent with established politics can be expected to reach new heights.

In short, established political elites are becoming an endangered species – and, far from knowing how to replace them, we have an institutionally-dangerous inability to appreciate the factors which have already made fundamental change inevitable.

Challenge #3 – an accelerating slump?

Everything described so far has been based on an interpretation which demonstrates an essentially gradual deterioration in prosperity. That, in itself, is serious enough – it threatens both a financial system predicated on perpetual growth, and political processes unable to recognise the implications of worsening public material well-being.

For context, SEEDS concludes that the average person in Britain, having become 11.5% less prosperous since 2003, is now getting poorer at rates of between 0.5% and 1.0% each year. EM economies, including both China and India, continue to enjoy growing prosperity, though this growth is now decreasing markedly, and is likely to go into reverse in the not-too-distant future.

Is it safe to assume, though, that prosperity will continue to erode gradually – or might be experience a rapid worsening in the rate of deterioration?

For now, no conclusive answer can be supplied on this point, but risk factors are considerable.

Here are just some of them:

1. The worsening trend in fossil fuel ECoEs is following a track that is exponential, not linear – and, as we have seen, there are likely to be limits to how far this can be countered by a switch to renewables.

2. The high probability of a financial crisis, differing both in magnitude and nature from GFC I, implies risks that there may be cross contamination to the real economy of goods, services, energy and labour.

3. Deteriorating prosperity poses a clear threat to rates of utilization, an important consideration given the extent to which both businesses and public services rely on high levels of capacity usage. Simple examples are a toll bridge or an airline, both of which spread fixed costs over a large number of users. Should utilization rates fall, continued viability would require increasing charges imposed on remaining users, since this is the only way in which fixed costs can be covered – but rising charges can be expected to worsen the rate at which utilization deteriorates.

4. Uncertainty in government, discussed above, may have destabilizing effects on economic activity.

There is a great deal more that could be said about “acceleration risk”, as indeed there is about the financial and governmental challenges posed by deteriorating prosperity.

But it is hoped that this discussion provides useful framing for some of the most important challenges ahead of us.

 

 

#148: Where now for energy?

WHY SUBSIDY HAS BECOME INESCAPABLE

What happens when energy prices are at once too high for consumers to afford, but too low for suppliers to earn a return on capital?

That’s the situation now with petroleum, but it’s likely to apply across the gamut of energy supply as economic trends unfold. On the one hand, prosperity has turned down, undermining what consumers can afford to spend on energy. On the other, the real cost of energy – the trend energy cost of energy (ECoE) – continues to rise.

In any other industry, these conditions would point to contraction – the amount sold would fall. But the supply of energy isn’t ‘any other industry’, any more than it’s ‘just another input’. Energy is the basis of all economic activity – if the supply of energy ceases, economic activity grinds to a halt. (If you take a moment to think through what would happen if all energy supply to an economy were cut off, you’ll see why this is).

Without continuity of energy, literally everything stops. But that’s exactly what would happen if the energy industries were left to the mercies of rising supply costs and dwindling customer resources.

This leads us to a finding which is as stark as it is (at first sight) surprising – we’re going to have to subsidise the supply of energy.

Critical pre-conditions

Apart from the complete inability of the economy to function without energy, two other, critical considerations point emphatically in this direction.

The first is the vast leverage contained in the energy equation. The value of a unit of energy is hugely greater than the price which consumers pay (or ever could pay) to buy it. There is an overriding collective interest in continuing the supply of energy, even if this cannot be done at levels of purchaser prices which make commercial sense for suppliers.

The second is that we already live in an age of subsidy. Ever since we decided, in 2008, to save reckless borrowers and reckless lenders from the devastating consequences of their folly, we’ve turned subsidy from anomaly into normality.

The subsidy in question isn’t a hand-out from taxpayers. Rather, supplying money at negative real cost subsidizes borrowers, subsidizes lenders and supports asset prices at levels which bear no resemblance to what ‘reality’ would be under normal, cost-positive monetary conditions.

In the future, the authorities are going to have to do for energy suppliers what they already do for borrowers and lenders – use ‘cheap money’ to sustain an activity which is vital, but which market forces alone cannot support.

How they’ll do this is something considered later in this discussion.

If, by the way, you think that the concept of subsidizing energy supply threatens the viability of fiat currencies, you’re right. The only defence for the idea of providing monetary policy support for the supply of energy is that the alternative of not doing so is even worse.

Starting from basics  

To understand what follows, you need to know that the economy is an energy system (and not a financial one), with money acting simply as a claim on output made possible only by the availability of energy. This observation isn’t exactly rocket-science, because it is surely obvious that money has no intrinsic worth, but commands value only in terms of the things for which it can exchanged.

To be slightly more specific, all economic output (other than the supply of energy itself) is the product of surplus energy – whenever energy is accessed, some energy is always consumed in the access process, and surplus energy is what remains after the energy cost of energy (ECoE) has been deducted from the total (or ‘gross’) amount that is accessed.

From this perspective, the distinguishing feature of the world economy over the last two decades has been the relentless rise in ECoE. This process necessarily undermines prosperity, because it erodes the available quantity of surplus energy. We’re already seeing this happen – Western prosperity growth has gone into reverse, and growth in emerging market (EM) economies is petering out. Global average prosperity has already turned down.

From this simple insight, much else follows – for instance, our recent, current and impending financial problems are caused by a collision between (a) a financial system wholly predicated on perpetual growth in prosperity, and (b) an energy dynamic that has already started putting prosperity growth into reverse. Likewise, political changes are likely to result from the failure of incumbent governments to understand the worsening circumstances of the governed.

Essential premises – leverage and subsidy

Before we start, there are two additional things that you need to appreciate.

The first is that the energy-economics equation is hugely leveraged. This means that the value of energy to the economy is vastly greater than the prices paid (or even conceivably paid) for it by immediate consumers. Having (say) fuel to put in his or her car is a tiny fraction of the value that a person derives from energy – it supplies literally all economic goods and services that he or she uses.

The second is that, ever since the 2008 global financial crisis (GFC I) we have been living in a post-market economy.

In practice, this means that subsidies have become a permanent feature of the economic landscape.

These issues are of fundamental importance, so much so that a brief explanation is necessary.

First, leverage. The energy content of a barrel of crude oil is 5,722,000 BTU, which converts to 1,677kwh, or 1,677,022 watt-hours. BTUs and watt-hours are ‘measures of work’ applicable to any source or use of energy. Human labour equates to about 75 watts per hour, so a barrel of crude equates to 22,360 hours of labour. At the (pretty low) rate of $10 per hour, this labour would cost an employer $223,603. Yet crude oil changes hands for just $65 which, undeniably, is a bargain. If the price of oil soared to $1,000/b, it would wreck the economy – but it would still be an extremely low price, when measured against an equivalent amount of human effort.

The economy, then, could be crippled by energy prices that would still be ultra-cheap in purely energy-content terms. More to the point, this could happen at prices that were still too low to ensure profitability in the business of energy supply.

The comparison between petroleum and its labour equivalent is meant to be solely illustrative – the relevant point is that the economy is gigantically leveraged to the ‘work value’ contained in all exogenous energy sources.

Second, the end of the market economy. The market economy works on a system of impersonal rewards and penalties. If you make shrewd investments, you’re likely to make a profit – but, if you act recklessly (or simply have a run of bad lack), you stand to lose everything. Failure, as penalised impersonally by market forces, is the flip-side of reward, itself (in theory) equally impersonal. Logically, market forces don’t allow you to have reward without the risk of failure. Using debt to leverage your position acts to increase both the scope for profit and the potential for loss.

The 2008 crisis was a culminating failure of reckless financial behaviour, by individuals, businesses, banks, regulators and policymakers. Left simply to the workings of the market, the penalties would have been on a scale commensurate with the preceding folly. Individuals and businesses which had taken on too much debt would have been bankrupted, as would those who had lent recklessly to them. If market forces had been allowed to work through to their logical conclusions, 2008 would have seen massive failures, bankruptcies and defaults – spreading out from those who ‘deserved’ to be wiped out to take in ‘bystanders’ with varying degrees of ‘innocence’ – whilst asset prices would have collapsed, and much of the banking system, as the primary supplier of credit, would have been destroyed.

Some economic purists have argued that this is exactly what should have happened, and that we will in due course pay a huge price for the ‘moral hazard’ of rescuing the reckless from the consequences of their actions.

They might well be right.

Be that as it may, though,  the point is that market forces were not allowed to work out to their logical conclusions. As well as simply rescuing the banks, the authorities set out on the wholesale rescue of anyone who had taken on too much debt. This was done primarily by slashing interest rates to levels that are negative in real terms (lower than inflation). Though described at the time as “temporary” and “emergency” in nature, these interventions are, for all practical purposes, permanent.

There’s irony in the observation that, though idealists of ‘the Left’ have dreamed since time immemorial of overthrowing the ‘capitalist’ system, the market economy has not been destroyed by its foes, but abandoned by its friends.

The Age of Subsidy

Critically for our purposes, what began in 2008 and continues to this day is wholesale subsidy. ZIRP has provided emergency and continuing sustenance for everyone who had borrowed recklessly in the years preceding the crash. It has also multiplied the incentive to borrow. Negative real interest rates are nothing more nor less than a hand-out to distressed borrowers, not only sparing them from debt service commitments that they could no longer afford, but inflating the market value of their investments, too.

Though less obvious than its beneficiaries, this subsidy has turned huge numbers into victims. Savers, including those putting resources aside for pensions, have been only the most visible of these victims. We cannot know who might have prospered had badly-run, over-extended businesses gone to the wall rather than continuing, in subsidised, “zombie” form, to occupy market space that might more productively have gone to new entrants. We do know that the young are victims of deliberate housing cost inflation.

There’s nothing new about subsidies, of course, and governments have often subsidised activities, either because these are seen to be of national importance, or because they have pandered to the influential interests on whom the subsidies have been bestowed.

Purists of the free market persuasion have long castigated subsidies as distortions of economic behaviour and they are, theoretically at least, quite right to think this.

The point, though, is that, since 2008, the entire economy has been made dependent on the subsidy of money priced at negative real levels.

Anyone who is ‘paid to borrow’ is, of necessity, in receipt of subsidy.

That we live in ‘the age of subsidy’ has a huge bearing on the outlook for energy. With this noted, let’s return to the role of energy in prosperity.

Prosperity in decline – turning-points and differentials

As we’ve noted, once the Energy Cost of (accessing) Energy – ECoE – passes a certain point, the remaining energy surplus becomes insufficient to grow prosperity, or even to sustain it. This point has now been reached or passed in almost all Western economies, so prosperity in those countries has turned down. Efforts to use financial adventurism to counter this effect have done no more than mask (since they cannot change) the processes that are undercutting prosperity, but have, in the process, created huge and compounding financial risks.

In the emerging market (EM) economies, prosperity continues to improve, but no longer at rates sufficient to offset Western decline. Global prosperity per person has now turned downwards from an extremely protracted plateau, meaning that the world has now started getting poorer. Amongst many other things, this means that a financial system predicated on the false assumption of infinite growth is heading for some form of invalidation. It also poses political and social challenges to which existing systems are incapable of adaption.

How, though, does the energy-prosperity equation work – and what can this tell us about the outlook for energy itself?

According to SEEDS (the Surplus Energy Economics Data System), global prosperity stopped growing when trend ECoE hit 5.4%. It might, at first sight, seem surprising that subsequent deterioration has been very gradual, even though ECoE has carried on rising relentlessly, now standing at 8.0%. This apparent contradiction is really all about the changing geographical mix involved – until recently, deterioration in Western prosperity had been offset by progress in EM countries, because the ECoE/growth thresholds differ between these two types of system.

Essentially, EM economies seem to be capable of continuing to grow their prosperity at levels of ECoE a lot higher than those which kill prosperity growth in Western countries.

The following charts illustrate the comparison, and show prosperity per capita (at constant 2018 values) on the vertical axis, and trend ECoE on the horizontal axis. For comparison with America, the China chart shows prosperity in dollars, converted at market exchange rates (in red) and on the more meaningful PPP basis of conversion (blue). For reference, ECoE at 6% is shown as a vertical line on both charts.

#148 energy comp US CH

As you can see, American prosperity had already turned down well before ECoE reached 6%. Chinese prosperity has carried on growing even though ECoE is now well above the 6% level.

How can China carry on getting more prosperous at levels of ECoE at which prosperity has already turned down, not just in America but in almost every other advanced economy?

There seem to be two main reasons for the different relationships between prosperity and ECoE in advanced and EM economies.

First, prosperity isn’t exactly the same thing in a Western or an EM economy – put colloquially, how prosperous you feel depends on where you live, and where you started from.

In America, SEEDS shows that prosperity per person peaked in 2005 at $48,660 per person (at 2018 values), and had fallen to $44,830 (-7.9%) by 2018. Over the same period, prosperity per person in China rose by an impressive 84% – but was still only $9,670 per person last year. Even that number is based on PPP conversion to dollars – converted into dollars at market exchange rates, prosperity per person in China last year was just $5,130.

Both numbers are drastically lower than the equivalent number for the United States. Not surprisingly, Chinese people feel (and are) more prosperous than they used to be, even at levels of prosperity that would amount to extreme impoverishment in America. Before anyone says that “America is a more expensive place to live”, conversion at PPP rates is supposed to take account of cost differentials – and, even in PPP terms, the average Chinese citizen is 78% poorer than his or her American equivalent.

The second critical differential lies in relationships between countries. Historically, trade relationships favoured Western over EM economies, though this has been changing, perhaps helping to explain the gradual narrowing in personal prosperity between developed and emerging countries.

Moreover, there are often quirks in the relationships between countries, even where they belong to the same broad ‘advanced’ or ‘emerging’ economic grouping. Germany is an example of this, having benefited enormously from a currency system which has been detrimental to other (indeed, almost every other) Euro Area country. For some time, Ireland, too, was a beneficiary of EA membership, though those benefits have eroded since the period of “Celtic Tiger” financial excess.

The conclusion, then, is that there’s no ‘one size fits all’ answer to the question of ‘where does ECoE kill growth?’, just as prosperity means different things in different types of economy.

It should also be noted that China’s ability to keep on growing prosperity at quite high levels of ECoE is not necessarily a good guide to the future. As things stand, China’s economy, driven as it by extraordinary levels of borrowing, is looking ever more like a Ponzi scheme facing a denouement.

The situation so far

Given how much ground we’ve covered, let’s take stock briefly of where we are.

We’ve observed, first, that the rise in trend ECoEs is in the process of undermining prosperity. Much of this has already happened – prosperity in most Western economies has now been deteriorating for at least a decade, whilst continued progress in EM economies is no longer enough to keep the global average stable. As ECoEs continue to rise, what happens next is that EM prosperity itself turns down, a process which will accelerate the rate at which global prosperity declines. SEEDS already identifies one major EM economy (other than China) where strong growth in prosperity will soon go into reverse.

Second, a world financial system predicated entirely on perpetual ‘growth’ in prosperity has become dangerously over-extended. Again, this observation isn’t something new. The inauguration, more than ten years ago, of mass subsidy for borrowers and lenders surely tells us that we’ve entered a new ‘era of abnormality’, in which subsidy is normal, and where historic principles (such as positive returns on capital) no longer apply.

If you stir energy leverage into this equation, an inescapable conclusion emerges. It is that we’re going to have to extend our current acceptance of ‘financial adventurism’ to the point where energy supply, just like borrowers and lenders, becomes supported by monetary subsidy.

The only way in which this might not happen would be if we could somehow escape from the implications of rising ECoE. Some believe that renewables will enable us to do this – after all, just as trend ECoEs for oil, gas and coal keep rising, those of wind and solar continue to move downwards.

This situation is summarised in the first of the following charts, which shows broad ECoE trends over the period (1980-2030) covered by SEEDS. As recently as 2000, the aggregate trend ECoE of renewables (shown in green) was above 13%, compared with only 4.1% for fossil fuels (shown in grey). Renewables are already helping to blunt the rise in ECoE, such that the overall number (in red) is lower than that of fossil fuels alone. We’re now pretty close to the point where the ECoE of renewables will be below that of fossil fuels.

On this basis, it’s become ‘consensus wisdom’ to assume that renewables will, like the 7th Cavalry, ‘ride to the rescue in the final reel’. Unfortunately, this comforting assumption rests on three fallacies.

The first is “the fallacy of extrapolation”, which is a natural human tendency to assume that what happens in the future will be an indefinite continuation of the recent past. (One of my mentors in my early years in the City called this “the fallacy of the mathematical dachshund”). The reality is much likelier to be that technical progress in renewables (including batteries) will slow when it starts to collide with the limits imposed by physics.

The second fallacy is that projections for cost reduction ignore the derivative nature of renewables. Building, say, a solar panel, a wind turbine or an electrical distribution system requires inputs currently only available courtesy of the use of fossil fuels. In this specialised sense, solar and wind are not so much ‘primary renewables’ as ‘secondary applications of primary fossil input’.

We may reach the point where these technologies become ‘truly renewable’, in that their inputs (such as minerals and plastics) can be supplied without help from oil, gas or coal.

But we are certainly, at present, nowhere near such a breakthrough. Until and unless this point is reached, the danger exists that that the ECoE of renewables may start to rise, pushed back upwards by the rising ECoE of the fossil fuel sources on which so many of their inputs rely. This is illustrated in the second chart, which looks at what might happen beyond the current time parameters of SEEDS. In this projection, progress in reducing the ECoEs of renewables goes into reverse because of the continued rise in fossil-derived inputs.

#148 energy comp segments

The third problem is that, even if renewables were able to stabilise ECoE at, say, 8% or so, that would not be anywhere near low enough.

Global prosperity stopped growing before ECoE hit 6%. British prosperity has been in decline ever since ECoE reached 3.6%, and an ECoE of 5.5% has been enough to push Western prosperity growth into reverse.

As recently as the 1960s, in what we might call a “golden age” of prosperity growth – when economies were expanding rapidly, and world use of cheap petroleum was rising at rates of up to 8% annually – ECoE was well below 2%.

In other words, even if renewables can stabilise ECoE at 8% – and that’s a truly gigantic ‘if’ – it won’t be low enough to enable prosperity to stabilise, let alone start to grow again.

Energy and subsidy –  between Scylla and Charybdis

The idea that we might need to subsidise energy ‘for the greater economic good’ is a radical one, but is not without precedent. Though the development of renewables has been accelerated in various countries by subsidies provided either by taxpayers or by consumers, the important precedent here doesn’t come from the solar or wind sectors, but from the production of oil from shales.

There can be no doubt that shale liquids, primarily from the United States, have transformed petroleum markets – without this production, it’s certain that supplies would have been lower, and prices could well have been a lot higher. Yet the supply of shale has owed little or nothing to the untrammelled working of the market. Rather, shale has received enormous subsidy.

Repeated studies have shown that shale liquids production isn’t ‘profitable’, because cash flow generated from the sale of production has never been sufficient to cover the industry’s capital costs, let alone to provide a return on capital as well. The economics of shale are too big a subject to be examined here, but the critical point is the rapidity with which production declines once a well is put on stream. This means that any company wanting to expand (or even to maintain) its level of production needs to keep drilling new wells – this is the “drilling treadmill” which, critically, has always needed more investment than cash flow from operations can supply.

Yet shale investment has continued, despite its record of generating negative free cash flow. It’s easy to attribute this to the support provided by gullible investors, but the broader picture is that shale producers, like ‘cash burners’ in other sectors, have been kept afloat by a tide of ultra-cheap capital made available by the negative real cost of capital.

In all probability, this is the pattern likely to be followed by the energy industries more generally, as profitability is crushed between the Scylla of rising costs and the Charybdis of straitened consumer circumstances.

In short, we’re probably going to have to ‘create’ the money to keep energy supplies flowing. If the argument becomes one in which energy is described as ‘too important to be left to the market’, energy will join a growing cast of characters – including borrowers, lenders and ‘zombie’ companies – kept in existence by the subsidy of cheap money.

 

#147: Primed to detonate

THE “WHAT?” AND “WHERE?” OF GLOBAL RISK

After more than a decade of worsening economic and financial folly, it can come as no surprise that we’re living with extraordinarily elevated levels of risk.

But what form does that risk take, and where is it most acute?

According to SEEDS – the Surplus Energy Economics Data System – the riskiest countries on the planet are Ireland, France, the Netherlands, China, Canada and the United Kingdom.

The risks vary between economies. Some simply have debts which are excessive. Some have become dangerously addicted to continuing infusions of cheap credit. Some have financial systems vastly out of proportion to the host economy. Some have infuriated the general public to the point where a repetition of the 2008 “rescue” would inflame huge anger. Many have combinations of all four sorts of risk.

Here’s the “top six” from the SEEDS Risk Matrix. Of course, the global risk represented by each country depends on proportionate size, so China (ranked #4 in the Matrix) is far more of a threat to the world economy and financial system than Ireland, the riskiest individual economy. It’s noteworthy, though, that the three highest-risk countries are all members of the Euro Area. It’s also noteworthy that, amongst the emerging market (EM) economies, only China and South Korea (ranked #9) make the top ten.

Risk 01 matrix top

Risk and irresponsibility

Before we get into methodologies and detailed numbers, it’s worth reflecting on why risk is quite so elevated. As regular readers will know, the narrative of recent years is that prosperity has been coming under increasing pressure ever since the late 1990s, mainly because trend ECoE (the energy cost of energy) has been rising, squeezing the surplus energy which is the source of all economic output and prosperity.

This is a trend which the authorities haven’t understood, recognizing only a vague “secular stagnation” whose actual root causes elude them.

Even “secular stagnation” has been unacceptable to economic and financial systems wholly predicated on “growth”. Simply put, there‘s been too much at stake for any form of stagnation, let alone deterioration, to be acceptable. The very idea that growth might be anything less than perpetual, despite the finite nature of the planet, has been treated as anathema.

If there isn’t any genuine growth to be enjoyed, the logic goes, then we’d better fake it. Essentially, nobody in authority has been willing to allow a little thing like reality to spoil the party, even if enjoyment of the party is now confined to quite a small minority.

Accordingly, increasingly futile (and dangerous) financial expedients, known here as adventurism, have been tried as “solutions” to the problem of low “growth”. In essence, these have had in common a characteristic of financial manipulation, most obvious in the fields of credit expansion and monetary dilution.

These process are the causes of the risk that we are measuring here, but risk comes in more than one guise. Accordingly, each of the four components of the SEEDS Risk Matrix addresses a different type of exposure.

These categories are:

– Debt risk

– Credit dependency risk

– Systemic financial risk

– Acquiescence risk

One final point – before we get into the detail – is that no attempt is made here to measure political risk in its broader sense. Through acquiescence risk, we can work out which populations have most to complain about in terms of worsening prosperity. But no purely economic calculation can determine exactly when and why a population decides to eject the governing incumbency, or when governments might be tempted into the time-dishonoured diversionary tactic of overseas belligerence. We can but hope that international affairs remain orderly, and that democracy is the preferred form of regime-change.

Debt risk

This is the easiest of the four to describe, and comes closest to the flawed, false-comfort measures used in ‘conventional’ appraisal. The SEEDS measure, though, compares debt, not with GDP but with prosperity, a very different concept.

Ireland, markedly the riskiest economy on this criterion, can be used to illustrate the process. At the end of 2018, aggregate private and public debt in Ireland is estimated at €963bn, a ratio of 312% to GDP (of €309 bn). Expressed at constant 2018 values, the equivalent numbers for 2007 (on the eve of the 2008 global financial crisis, which hit Ireland particularly badly) were debt of €493bn, GDP of €198bn and a debt/GDP ratio of 249%.

In essence, then, debt may be almost twice as big (+95%) now as it was in 2007, but the debt ratio has increased by ‘only’ 25% (to 312%, from 249%), because reported GDP has expanded by 56%.

Unfortunately, this type of calculation treats GDP and debt as discrete items, with the former unaffected by changes in the latter. The reality, though, is very different. Whilst GDP has increased by €111bn since 2007, debt has expanded by €470bn. Critically, much of this newly-borrowed money has flowed into expenditures, which serves to drive up the activity measured as GDP.

According to SEEDS, growth without this simple spending of borrowed money would have been only €13bn, not €111bn. Put another way, 89% of all “growth” reported in Ireland since 2007 has been nothing more substantial than the effect of pouring cheap credit into the system, helped, too, by the “leprechaun economics” recalibration of GDP which took place in 2015.

Of course, the practice of spending borrowed money and calling the result “growth” didn’t begin after the 2008 crash. Back in 2007, adjusted (“clean”) GDP in Ireland (of €172bn) was already markedly (13%) lower than headline GDP (€198bn), and the gap is even wider today, with “clean” GDP (of €184bn) now 40% lower than the reported number.

Even “clean” GDP isn’t a complete measure of prosperity, though, because it excludes ECoE – that proportion of output that isn’t available for other purposes, because it’s required to fund the supply of energy itself.

Where ECoE is concerned, Ireland is a disadvantaged economy whose circumstances have worsened steadily in recent years. Back in 2007, Ireland’s ECoE (of 6.7%) was already markedly worse than the global average (5.4%). By 2018, the gap had widened from 1.3% to 3.2%, with Ireland’s ECoE now 11.2% (and the world average 8.0%). An ECoE this high necessarily kills growth, which is why aggregate prosperity in Ireland now is only fractionally (2%) higher than it was in 2007, even though population numbers have grown by 10%.

The results of this process, where Ireland is concerned, have been that personal prosperity has declined by 7% since 2007, whilst debt per person has risen by 78%. The conclusion for Ireland is that debt now equates to 589% of prosperity (compared with 308% in 2007), and it’s hard to see what the country can do about it. If – or rather, when – the GFC II sequel to 2008 turns up, Ireland is going to be in very, very big trouble.

These are, of course, compelling reasons for the Irish authorities to bend every effort to ensure that Britain’s “Brexit” departure from the European Union happens as smoothly as possible. If the Irish government really understood the issues at stake, ministers would be exerting every possible pressure on Brussels to step back from its macho posturing and give Mrs May something that she can sell to Parliament and the voters.

There’s a grim precedent for Dublin not understanding this, though – in the heady “Celtic tiger” years before 2008, nobody seems to have batted an eyelid at the increasingly reckless expansion of the Irish banking system.

Risk 02 debt

Credit dependency

As we’ve seen, adding €111bn to Irish GDP since 2007 has required adding €470bn to debt. This means that each €1 of “growth” came at a cost of €4.24 in net new borrowing. It also means that annual net borrowing averaged 14% of GDP during that period. This represents very severe credit dependency risk – in short, the Irish economy would suffer very serious damage in the event even of a reduction, let alone a cessation, in the supply of new credit to the economy.

Remarkably, though, there is one country whose credit dependency problem is far worse than that of Ireland – and that country is China.

The Chinese economy famously delivers growth of at least 6.5% each year, and reported GDP has more than doubled since 2008, increasing by RMB 51 trillion, from RMB37.7tn to an estimated RMB89tn last year.

Less noticed by China’s army of admirers has been a quadrupling of debt over the same period, from RMB53tn (at 2018 values) in 2008 to RMB219tn now. There also seem to be plausible grounds for thinking that China’s debts might be even bigger than indicated by published numbers.

This means that, over the last ten years, annual borrowing has averaged an astonishing 23% of GDP. No other economy comes even close to this, with Ireland (14.1%) placed second, followed by Canada (9.5%) in third, and South Korea (8.6%) a distant fourth. To put this in context, the ratios for France (8.1%) and Australia (7.5%) are quite bad enough – the Chinese ratio is as frightening as it is astonishing.

The inference to be drawn from this is that China is a ‘ponzi economy’ like no other. The country’s credit dependency ratio represents, not just extreme exposure to credit tightening or interruption, but an outright warning of impending implosion.

There are signs that the implosion may now be nearing. As well as slumping sales of everything from cars to smartphones, there are disturbing signs that industrial purchases, of components ranging from chips to electric motors, are turning downwards. Worryingly, companies have started defaulting on debts supposedly covered very substantially by cash holdings, the inference being that this “cash” was imaginary. Worse still, the long-standing assumption that the country could and would stand behind the debts of all state-owned entities (SOEs) is proving not to be the case. In disturbing echoes of the American experience in 2008, there are reasons to question why domestic agencies accord investment grade ratings to such a large proportion of Chinese corporate bonds.

How has this happened? The answer seems to be that the Chinese authorities have placed single-minded concentration on maintaining and growing levels of employment, prioritizing this (and its associated emphasis on volume) far above profitability. Put another way, China seems quite prepared to sell products at a loss, so long as volumes and employment are maintained. This has resulted in returns on invested capital falling below the cost of servicing debt capital – and an attempt to convert corporate bonds into equity was a spectacular failure, coming close to crashing the Chinese equity market.

Risk 03 credit

Systemic exposure

Debt exposure and credit dependency are relatively narrow measures, in that both concentrate on indebtedness. Critical though these are, there is a broader category of exposure termed here systemic risk, and this is particularly important in terms of the danger of contagion between economies.

The countries most at risk here are Ireland (again), the Netherlands and Britain. All three have financial sectors which are bloated even when compared with GDP. But the true lethality of systemic risk exposure only becomes fully apparent when prosperity is used as the benchmark.

At the most recent published date (2016), Dutch financial assets were stated at $10.96tn (€10.4tn), or 1470% of GDP. The SEEDS model assumes that the ratio to GDP now is somewhat lower (1360%), which implies financial assets unchanged at €10.4tn.

As we’ve seen with Ireland, measurement based on GDP produces false comfort, because GDP is inflated by the spending of borrowed money, and ignores ECoE. In the Netherlands, growth in GDP of €82bn (12%) between 2007 and 2018 needs to be seen in the context of a €600bn (32%) escalation in debt over the same period. This means that each €1 of reported “growth” has required net new borrowing of €7.40. Without this effect, SEEDS calculates that organic growth would have been just €8bn (not €82bn), and that ‘clean’ GDP in 2018 was €619bn, not €767bn.

The further deduction of ECoE (in 2018, 10.5%) reduces prosperity to €554bn. This is lower than the equivalent number for 2007 (€574bn), and further indicates that the prosperity of the average Dutch person declined by 8% over that period.

Though aggregate prosperity is slightly (3.5%) lower now than it was in 2007, financial assets have expanded by almost 40%, to €10.4tn now from €7.47tn (at 2018 values) back in 2007. This means that financial assets have grown from 1303% of prosperity on the eve of GFC I to 1881% today.

As the next table shows, this puts Holland second on this risk metric, below Ireland (3026%) but above the United Kingdom (1591%). Japan (924%) and China (884%) are third and fourth on this list.

Needless to say, the Irish number looks lethal but, since Ireland is a small economy, equates to financial assets (of €4.9tn) that are a lot smaller than those of the Netherlands (€10.4tn). Likewise, British financial assets are put at £23.3tn, a truly disturbing number when compared with GDP of £2tn, let alone prosperity of £1.47tn.

The conclusion on this category of risk has to be that Ireland, Holland and Britain look like accidents waiting to happen. Something not dissimilar might be said, too, of Japan and China. Japan’s gung-ho use of QE has resulted in half of all JGBs (government bonds) being owned by the BoJ (the central bank), whilst huge financial assets (estimated at RMB417tn) underscore the risk perception already identified by China’s dependency on extraordinary rates of credit creation.

Risk 04 systemic

Acquiescence risk

The fourth category of risk measured by SEEDS concentrates on public attitudes rather than macroeconomic exposure. Simply put, we can assume that, when the GFC II sequel to the 2008 global financial crisis (GFC I) hits, governments are likely to try to repeat the “rescue” strategies which bought time (albeit at huge expense) last time around. But will the public accept these policies? Or will there be a huge popular backlash, something which could prevent such policies from being implemented?

It’s not difficult to envisage how this happens. If we can picture some politicians announcing, say, a rescue of the banks, we can equally picture some of their opponents pledging to scrap the rescue at the earliest opportunity, and take the banks into public ownership, pointing out that stockholder compensation will not be necessary because, in the absence of  a taxpayer bail-out, the worst-affected banks have zero equity value anyway. Simply put, this time around there could be more votes in the infliction of austerity on “the wealthy” than there will be in bailing them out. It’s equally easy to picture, at the very least, public demonstrations opposing such a rescue.

Even at the time, and more so as time has gone on, the general public has nurtured suspicions, later hardening into something much nearer to certainties, that the authorities played the 2008 crisis with loaded dice. One obvious source of grievance has been the management of the banking crash. The public may understand why banks were rescued, but cannot understand why the rescue included the bankers as well, whose prior irresponsibility is assumed by many to have been the cause of the crisis – especially given the unwillingness of governments to rescue those in other occupations, such as manufacturing, retail and hospitality.

The 2008 crisis was followed by a fashion for “austerity”, in which the public was expected to accept lean times as part of a rehabilitation of national finances after debts and deficits had soared during GFC I. Unfortunately, the imposition of “austerity” has looked extremely one-sided. Whilst public services budgets have been cut, the authorities have operated policies which have induced extraordinary inflation in asset prices. These benefits, for the most part enjoyed by a small minority, haven’t even been accompanied by fiscal changes designed to capture at least some of the gains for the taxpayer.

The word ‘hypocrisy’ has been woven like a thread into the tapestry of post-2008 trends, which are widely perceived as having inflicted austerity on the many as the price of rescuing the few. It hardly helps when advocates of “austerity” seem not to practice it themselves. Policies since 2008 have been extraordinarily divisive, not just between “the rich” and the majority, but also between the old (who tend to own assets) and the young (who don’t).

In short, the events of 2008 have created huge mistrust between governing and governed. This might not have mattered quite so much had the prosperity of the average person continued to grow, but, in almost all Western countries, this has not been the case. Whatever might be claimed about GDP, individuals sense – rightly – that they’re getting poorer. We’ve already seen the results of this estrangement, in the election of Donald Trump, the “Brexit” vote in Britain and the rise of insurgent (aka “populist”) parties in many European countries. Latterly, France has witnessed the eruption of popular anger in the gilets jaunes movement, something which might well be replicated in other countries.

For reasons which vary between countries – but which have in common a complete failure to understand deteriorating prosperity – established policymakers have seemed blinded to political reality by “the juggernaut effect”.

Where, though, is acquiescence risk most acute? The answer to this seems to lie less in the absolute deterioration in average prosperity than in the relentless squeeze in discretionary (“left in your pocket”) prosperity – simply put, how much money does a person have left at the end of the week or month, after taxes have been paid, and essential expenses have been met?

This discretionary effect helps to explain why the popular backlash has been so acute in France. At the overall level, the decline in French prosperity per person since 2007 has been a fairly modest 6.3%, less severe than the experiences of a number of other countries such as Italy (-11.6%), Britain (-10.3%), Norway (-8.4%) and Greece (-8..0%). Canadians (-8.1%) and Australians (-9.0%), too, have fared worse than the French.

Take taxation into account, though, and France comes top of the league. Back in 2007, prosperity per person in France was €28,950, which after tax (of €17,350) left the average person with €11,600 in his or her pocket. Since then, however, whilst prosperity has declined by €1,840 per person, tax has increased (by €1,970), leaving the individual with only €7,790, a 33% fall since 2007.

In no other country has this rapidity of deterioration been matched, though discretionary prosperity has fallen by 28% in the Netherlands, by 24% in Britain, by 23% in Australia and by 18% in Italy. If this interpretation makes sense of the popularity of the gilets jaunes (and makes absolutely no sense of the French authorities’ responses), it also suggests that the Hague, London and perhaps Canberra ought to be preparing themselves for the appearance of yellow waistcoats on their streets.

Risk 05 acquiescence

#146: Fire and ice, part three

SHAPING THE AGENDA

The project entitled Fire & Ice has had two very definite objectives. One is to make a synopsis of the economic and financial situation. The other is to start a debate about what the most appropriate responses might be. By “responses”, I wasn’t thinking of what individuals might do in preparation, though suggestions on this could be most valuable. Rather, the focus is on how the authorities might react to circumstances as they develop.

Of course, who “the authorities” might be when the challenge arises is less obvious than it might once have seemed. After more than three decades in the ascendancy, the ‘liberal globalist’ elites are in retreat. Political insurgents – a term which I prefer to the more loaded “populist” label – are bringing fresh ideas and new energy to the debate.

But it is far from clear that these newcomers have a grasp of economic reality that is any better than that of their ‘establishment’ opponents. They’re good at knowing what the public doesn’t like, but sketchy, at best, about what can realistically be offered instead.

I like to think that energy-based analysis of the economy provides answers to questions which baffle ‘conventional’ economic interpretation. I also like to think that we have both a coherent narrative and an effective model.

But where do we go from here?

The best place to start might be with a short list of the issues most demanding current attention. Five subjects dominate this list, and these are:

– The almost tangible pace of economic deterioration, most obviously (though by no means exclusively) in China.

– The complete bafflement of ‘the powers that be’ about the processes that are dismantling the established economic, social and political world-view.

– The looming crisis of a financial structure built on reckless credit and monetary adventurism.

– The rising anger of ‘ordinary’ people who, without knowing exactly how or why, suspect that they’ve been ‘taken for a ride’ by ‘the establishment’.

– The impending revelation that’s likely to boost popular anger to levels dwarfing anything yet experienced.

The big one – ‘hidden in plain sight’

The latter, highly incendiary issue is the unfolding failure of the ability to provide pensions to any but a super-wealthy minority. The collapse of returns on investment has crippled the viability of most employer and individual savings provision. Meanwhile, Tier 1 provision (which is financed directly out of taxation, rather than funded like private schemes) is already well on the way to becoming unaffordable, not least because – as we’ve seen in a previous discussion – tax revenues are leveraged to the ongoing deterioration in prosperity in almost all Western economies.

The disintegration of pension provision is a crisis ‘hidden in plain sight’. Back in 2017, the World Economic Forum called attention to a “global pensions timebomb”, calculating that, for a group of eight countries, a gap already standing at $67 trillion was set to reach $428tn by 2050. (You can find the WEF press release here, and it links to the report itself. Both should be mandatory reading).

The WEF made various worthy suggestions – including delaying retirement ages, and enhancing popular understanding of pensions systems – but these can do no more than scratch the surface of a problem caused by a collapse in returns which is itself a direct consequence of deliberate (though not necessarily voluntary) economic policy.

Broadly speaking, people in Western countries have a long-established expectation, which is that they’ll retire in their early 60s, and then receive a pension equivalent to about 70% of their final in-work incomes. We’re close to a point at which retirement before the age of 70 will become impossible to finance and, even then, it’s unlikely that the 70%-of-income benchmark will be affordable.

We’ll return to this subject later in this discussion. But the critical point is that the anger that will erupt when the public finds out about this is likely to be extreme.

The central issue

The best way to impose a structure on these disparate issues is to start with their common cause – a deterioration in prosperity that’s becoming impossible to disguise, and which the authorities themselves seem wholly unable to comprehend.

If you’re a regular visitor to this site, you’ll know that the central contention here is that the economy is an energy system, not a financial one. This interpretation is so obviously in keeping with the facts that it can be hard to comprehend the inability of ‘conventional’ thinkers to understand it.

For example, anyone who thinks that energy is ‘just another input’ should try picturing what would happen if the supply of energy to an economy was cut off, just for a few days, let alone for several months. Even an outage lasting days would bring the economy to a halt – and a few months without energy would induce economic and social collapse.

Those who contend that energy is ‘just a small percentage’ of economic output might reflect, first, that the foundations are ‘just a small percentage’ of a tower-block, but we wouldn’t build one without them. They might also try to name anything within the gamut of goods and services that can be produced without energy. Moreover, if energy did absorb a large proportion of the economy, the obvious inference is that the non-energy remainder would have to have shrunk dramatically. Additionally, of course, it’s becoming ever harder to believe that GDP numbers swelled by the spending of borrowed money are any kind of realistic denominator for calculating the proportionate role played by energy.

To be sure, it’s highly unlikely that energy supply to an economy would be cut off in its entirety (though it’s rather less unlikely that an economy could lose the ability to pay for it). But the point here is the centrality of energy to literally all economic activity. Equally, it’s surely obvious that the energy which drives all economic activity (other than the supply of energy itself) is surplus energy – that is, the energy to which we have access after we’ve deducted the energy consumed in the access process.

That equation is measured here using ECoE (the energy cost of energy). It is no coincidence at all that an exponential rise in the trend ECoEs of fossil fuels has paralleled the increasing use of financial adventurism –  the less generous might call it ‘manipulation’ – in futile efforts to stave off economic stagnation.

Of course, you can’t fix the ECoE problem by pouring cheap credit and cheaper money into the system, but what you can achieve is the creation of enormous bubbles which are destined to burst, scattering debris right across the financial and economic landscape.

Optimists assert that we needn’t worry about the ECoE problem with oil, gas and coal, because we can transition to renewable energy sources. This claim might be a valid one, though the weight of evidence strongly suggests otherwise. Where the optimists do depart completely from reality is in the assertion that this transition can happen seamlessly, without any check to “growth”, without any noticeable disruption and, needless to say, without any hardship which might weaken the economic or social status quo.

Irrespective of where transition to renewables might take us in the future, the issues now are twofold. The first is that the rising trend in ECoEs is being reflected in a squeeze in prosperity, a process which is often labelled “secular stagnation”, but which is proving impossible to counter using the conventional tool of financial stimulus.

The second is that exercises in denial have created ever-growing imbalances within the financial system, imbalances which are manifesting themselves, not just in asset price bubbles and in excessive indebtedness, but in credit dependency, and in the destruction of pension provision.

These constitute specific risks, which are modeled by SEEDS, and might be addressed in a subsequent analysis. For now, though, here are the risk categories identified by the model:

Debt risk. This is calibrated by comparing debt with prosperity, rather than with the increasingly unrealistic GDP benchmark.

Credit dependency. This is a measure of annual rates of borrowing, and identifies exposure to any squeeze in, or cessation of, the continuity of credit.

Systemic exposure. This assesses contagion risk by measuring the scale of financial assets in proportion to prosperity.

Acquiescence risk. This measure looks at how rapidly personal prosperity has fallen, and is continuing to fall. The aim here is to assess the extent to which arduous ‘rescue plans’, which might be labelled ‘restorative austerity’, are likely to meet with popular opposition.

Primed to detonate

The pensions problem is critical here, for two quite distinct reasons. The first is that the creation of the pensions “timebomb” tells us a very great deal about economic abnormality, and the grotesque failure of policy.

The second is that this “timebomb” might detonate in the foundations of the current system of governance. It certainly has the potential to dwarf all other popular grievances.

According to the WEF study, the pensions gap in the United States stood at $27.8tn in 2015. It is growing at a real compound rate of about 4.7% annually, and is likely to have reached almost $32tn by the end of last year. In Britain, a number stated at $8tn (£5.25tn) for 2015 is growing by more than 4% each year, and is likely now to be well over £7tn. In both instances, the rate at which the gap is widening far exceeds any remotely realistic rate of growth in GDP.

As regular readers know, reported GDP is flattered by the spending of huge amounts of borrowed money, and ignores the critical issue of ECoE. For 2018, SEEDS estimates American aggregate prosperity at $14.7tn, significantly smaller than GDP of $20.5tn. British prosperity is calculated at £1.47tn last year, compared with GDP of £2tn.

This means that, in the United States, the pension gap has already reached 210% of prosperity (and 155% of GDP), and is likely to reach 300% of prosperity by 2026.

In Britain, it’s likely that the gap is already over 470% of prosperity, and will reach 660% by 2026. This financial ‘hostage to the future’ is in addition to debt put at 365% of prosperity. Moreover, financial assets (a measure of the size of the financial system) are estimated at close to 1600% of British prosperity (and about 1125% of GDP). This looks a potentially lethal cocktail for any economy founded on ultra-cheap credit and a fiat monetary system

There are two main reasons for the truly frightening rates at which pension gaps have emerged, and the equally worrying rates at which they are increasing. First, the ability to fund state-provided pensions is coming under tightening pressure because of the leveraged impact of adverse prosperity trends on the scope for taxation.

The second is the collapse of returns on invested capital. According to the WEF report, historic returns of 8.6% on US equities and 3.6% on bonds have now slumped to, respectively, 3.45% and just 0.15% on a forward basis. This makes it wholly impossible, not just in America but across the world, for private investment to fill any part of the widening chasm in state provision.

The collapse in rates of return is the clincher here, and is a direct consequence of the adoption of ZIRP (zero interest rate policy). Put simply, the pensions “timebomb” is something that we’ve wished on ourselves through monetary policy. Introduced back in 2008, the supposedly “temporary” and “emergency” policy expedient of ZIRP has already long-outlasted the duration of the Second World War, and there’s no prospect, now or later, of a return to “normal” rates (which can be thought of as rates exceeding inflation by at least 2.5%).

Policies like ZIRP need to be interpreted as economic signals, sometimes (as now) determined less by voluntary policy decision than by the force of circumstances. The ‘force of circumstances’ which dictated the adoption of ZIRP was a debt mountain which borrowers had become wholly unable to service at normal rates of interest.

It’s vital to note that ZIRP wasn’t something chosen capriciously by the authorities. Rather, it was an expedient forced upon them by economic conditions. Behind the apparent “borrow, don’t save” signal represented by ZIRP lies a structural signal, which is that “the economy can no longer afford saving”. When that happens, it’s the economic equivalent of the way in which some ships or aeroplanes can be kept operational by cannibalizing others.

Politically, there’s no way out of this which doesn’t inflame popular anger. Historically, as mentioned earlier, people in Western countries have assumed that they will retire in their early 60s, receiving, in retirement, roughly 70% of the income they earned at the close of their working lives. The sums here suggest that even raising retirement ages to 70 won’t keep the 70% target affordable.

I’ll leave you to reflect on what the reaction is likely to be when the plight of the “ordinary” person becomes known, and is contrasted with the circumstances of a privileged minority. However, any political establishment which supposes that, whilst pensions become unaffordable for most, a minority can continue retire on generous incomes, and with the cushion of substantial accumulated wealth, is guilty of very dangerous self-deception.

Crunch point

The harsh reality is that we’ve built systems – financial, economic, social and political – which can only function when prosperity is growing. These systems can survive recessions, or even depressions, presupposing that neither is unduly protracted, and is followed by a return to growth. When – as now – that doesn’t happen, the promises that we made to ourselves in order to weather the bad times rapidly become incapable of being honoured.

Ultimately, any financial system is a set of promises, and functions only if those promises can be kept.

It has to be glaringly obvious, too, that the historic cushion of growing prosperity has enabled us to indulge in luxuries that are now becoming unaffordable. The term “luxuries” doesn’t refer to trinkets like gadgets, expensive holidays and the two- or three-car family. Rather, it refers to assumptions and practices that can no longer be afforded.

High on this list lies the indulgence of ideological extremism in economic organisation. If there was ever a time when society could afford either the fanaticism of “nationalising everything”, or the contrary fanaticism of “privatising everything”, that time passed at least two decades ago. What is required now is the pragmatism which surely leads to the “horses for courses” preference for a mixed economy, in which both the state and private enterprise concentrate on what each does best.

Other luxuries that we can no longer afford include massive gaps between the poorest and the wealthiest. This was an affordable luxury when everyone was getting a little more prosperous with each passing year. When your own circumstances are improving, it’s not difficult to accept the extreme wealth of your neighbour – but this tolerance will dissolve very quickly indeed when exposed to the solvent of generally deteriorating prosperity.

This, through its direct link to political insurgency (aka “populism”), brings us back to the immediate situation. Public dissatisfaction has thus far been fueled by discontents likely to be dwarfed by anger yet to come, as inflated asset prices explode and the reality of deteriorating prosperity can no longer be disguised. The Chinese economy, which has accounted for 36% of all global growth since 2008, is now deteriorating markedly, the inevitable fate of any system founded on truly reckless rates of borrowing. “Growth” of 6-7% ceases to impress when you have to borrow about 25% of GDP each year to make it happen.

Few Western economies are in much better condition, yet politicians continue to promise “growth”, and remain in ignorance about the trends that are making such promises an absurdity. Perhaps the greatest risk of all is that lessons not learned in 2008 will be no better understood in the next (and much larger) crisis described here as GFC II.

Stir the pensions reality into that mix and the result is an inflammable cocktail. We may know that current incumbencies cannot adapt to the new realities, but the insurgents have yet to demonstrate a better grasp of reality.

Where we need to go next is to start helping craft a programme which, whilst it cannot remove impending challenges, might at least enable us to adjust to them.

= = = = =

#146 pensions returns 03

 

#145: Fire and ice, part two

“THE JUGGERNAUT EFFECT”

Although it was something of a detour from the theme of fire and ice, our previous discussion about “Brexit” does have one point of relevance to that theme. Here’s why.

All things considered, there seems to be an utterly compelling case for intervention in the dysfunctional “Brexit” process by the “adults” in European governments. Yet, even at this very late stage, no such intervention has happened. Governments seem to see no alternative to letting London and Brussels – but mostly Brussels – make a complete hash of the whole process. Indeed, only now do the governments of the countries most affected (Ireland and France) seem even to be implementing contingency plans for an adverse outcome.

Of course, you might jump to the conclusion that irrationality reigns in European capitals, and especially in Dublin and Paris. But it’s surely obvious that this is part of a much wider process, one which we can think of as a form of shock-paralysis.

Essentially, the idea explored here is that governments around the world have been paralysed into inaction, not so much by fear alone as by a simple inability to understand what’s happening around them. Nothing, it seems to them, is happening rationally. They don’t really understand why so many amongst the general public are so angry – and they certainly don’t even begin to understand what’s happening to the economy.

I call this shock-paralysis “the juggernaut effect”.

Shock-paralysis

The word “juggernaut” seems to derive from Sanskrit, and refers to an enormous waggon carrying the image of a Hindu god. The figurative meaning is of an irresistible force, flattening anyone foolish enough to stand in its way.

Rationally, you’d think that anybody standing in the path of a “juggernaut” ought to be making every effort to escape. But it’s quite likely that shock, fear and incomprehension will have a paralysing effect, overwhelming rational faculties, leaving him or her rooted to the spot.

That’s a useful way to describe the effects that current economic (and broader) trends are having. It doesn’t just apply to governments, of course, and it’s prevalent amongst the general public, too.

Just as the person standing in front of the “juggernaut” is all too well aware of its lethality, today’s leaders and opinion-formers surely know at least something about the financial, economic, political and social forces converging on them.

But they seem incapable of doing anything about it.

A big part of this paralysis is incomprehension – any problem becomes infinitely harder to tackle if you don’t understand why it’s happening. And there are reasons enough for policy-makers, and ‘ordinary’ people too, to feel completely baffled.

The irrational economy

You don’t need to be a committed Keynesian – indeed, you need only numeracy – to understand the basic principles of economic stimulus.

If economic performance is sluggish, activity can be stimulated by pushing liquidity into the system, either through fiscal or through monetary policy. If too much stimulus is injected, though, there’s a risk that the economy will overheat, with growth exceeding the sustainable trend. Rising inflation is one of the most obvious symptoms of an over-heating economy.

Here, though, is the conundrum, for anyone trying to understand how the economy is performing.

Since the 2008 global financial crisis (GFC I), the authorities have pushed unprecedentedly enormous amounts of stimulus into the system.

We ought, long before now, to have experienced overheating, with growth rising to levels far above trend.

This simply hasn’t happened.

This should have been accompanied by surging inflation, most obviously in commodities like energy, minerals and food, but across the whole gamut of goods and services, too, with wage rates rising rapidly as prices soar.

Again, this simply hasn’t happened.

To be sure, there’s been dramatic inflation in asset prices, and that’s both important and dangerous. But the broader point is that neither super-heated growth, nor a surge in price and wage inflation, have turned up, as logic, experience and basic mathematics all tell us that they should.

Pending final data for 2018, it’s likely that global GDP last year will have been about 34% higher than it was back in 2008. Allowing for the increase in population numbers, GDP per capita is likely to have been about 20% larger in 2018 than it was ten years previously. This isn’t exactly super-heated growth. According to SEEDS, world inflation stands at about 2.5% which, again, is nowhere near the levels associated with an over-heating economy. Far from soaring, the prices of commodities such as oil are in the doldrums.

Price (and other) data is telling us that the economy has stagnated. But the quantity of stimulus injected for more than a decade says that it should be doing precisely the opposite.

There can be no doubt whatsoever about the scale of stimulus. The usual number attached to sums created through QE by central banks is in the range $26-30 trillion, but that’s very much a narrow definition of stimulus. Ultra-loose monetary policy, combined with not inconsiderable fiscal deficits, have been at the heart of an unprecedented wave of stimulus.

Expressed in PPP-converted dollars at constant values (the convention used throughout this analysis), governments have borrowed about $39tn, and the private sector about $71tn, since 2008. On top of that, we’ve wound down pension provision in an alarming way, as part of the broader effects of pricing money at negative real levels, which destroys returns on invested capital.

Even if we confine ourselves to QE and borrowing, however, stimulus since 2008 can be put pretty conservatively at $140tn.

That’s roughly 140% of where world PPP GDP was back in 2008. You might think of it as the injection of 12-14% of GDP each year for a decade.

That’s an unprecedentedly gigantic exercise in stimulus.

And the result? In contrast to at least $140tn of stimulus, world GDP is perhaps $34tn higher now than it was ten years previously. Price and wage inflation is subdued, and the prices of sensitive commodities have sagged. The prices of assets such as stocks, bonds and property have indeed soared – but one or more crashes will take care of that.

By now – indeed, long before now – anyone in government ought to have been asking his or her expert advisers to explain what on earth is going on. Assuming that Keynes wasn’t mistaken (and simple mathematics proves that he wasn’t), the only frank answer those advisers can give is that they just don’t understand what’s been happening.

Questions without answers?

The utter failure of gigantic stimulus to spur the economy into super-heated growth (and surging inflation) is reason enough for baffled paralysis. But there are plenty of other irrationalities to add to the mix.

If you were in government, or for that matter in business or finance, then as well as asking your advisers about the apparent total breakdown in the stimulus mechanism, you might want to put these questions to them, too:

– Why has a capitalist economic system become dependent on negative real returns on capital?

– Why, since the shock therapy of the 2008 global financial crisis (GFC I), have we accelerated the pace at which we’re adding to the debt mountain?

– Why, seemingly heedless of all past experience, have we felt it necessary to pour vast amounts of cheap money into the system?

– Why have the prices of assets (including stocks, bonds and property) soared to levels impossible to reconcile with the fundamentals of valuation?

– Why has China, reputedly the world’s primary engine of growth, found it necessary to resort to borrowing on a gargantuan scale?

This last question deserves some amplification. Pending final data, we can estimate that Chinese debt has increased to about RMB 220tn now, from less than RMB 53tn (at 2018 values) at the start of 2008. These numbers exclude what are likely to be very large quantities of debt created in what might most politely be called the country’s “informal” credit system.

So, why does an economy supposedly growing at between 6% and 7% annually need to do much borrowing at all?  Put another way, how meaningful is “growth” in GDP of 6-7%, when you have to borrow about 25% of GDP annually, just to keep it going?

And this prompts several more questions. For starters, why are the Chinese authorities, hitherto esteemed for their financial conservatism, presiding over the transformation of their economy into a debt-ponzi? Second, can ‘the mystique of the east’ explain why the world’s markets are seemingly either ignorant, and/or complacent, about the creation of a financial time-bomb in China?

The juggernaut effect

Even these questions don’t exhaust the almost endless list of disconnects in our increasingly surreal economic plight, but they surely give us more than enough explanations for the paralysing “juggernaut effect” in the corridors of power.

Put yourself, if you will, into the shoes of someone trying to formulate policy. Two things are obvious to you, and either one of them would be a grave worry. Together, they’re enough to overwhelm rational calculation.

First, you know that there are some very, very dangerous trends out there. In the purely financial arena, you’re aware that debt has become excessive, whilst the system seems to have become reliant on a never-ending tide of cheap credit.

If your intellectual leanings are towards market economics, you’ll also have realised that pricing money at rates below inflation amounts to an enormous subsidy. Politically, that subsidy is going to the wrong people. If you came into government with business experience, you’ll also know that we’ve witnessed the destruction of returns on capital, which makes no kind of sense from any business or investment point of view.

You might know, too, that the viability of pension provision has collapsed, creating what the World Economic Forum has called “a global pensions timebomb”. If the public ever finds out about that, the reaction could dwarf whatever political travails you might happen to have at the moment.

Lastly – on your short-list of nightmares – is the strong possibility that some event, as yet unknown, will trigger a wave of defaults and a collapse in the prices of property and other assets.

Your second worry, perhaps even bigger than your list of risks, is that you don’t really understand any of this. Your economic advisers can’t explain why stimulus, though carried to (and far beyond) the point of danger, hasn’t worked as the textbooks (and all prior experience) say it should. If there’s anything worse than a string of serious problems and challenges, it’s a complete lack of understanding.

Without understanding, the policy cupboard is bare. You don’t know what to do next, because anything you do might have results that don’t match expectations, making matters worse rather than better.

It might be better to do nothing.

In short, you feel as though you’re making it up as you go along, in the virtual certainty that something horribly unpleasant is going to hit you, with little or no prior warning.

Welcome to “the juggernaut effect”.